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Commentary: It's Simple: Make Fund Managers Spell Out The Risks



Stanford University economist William F. Sharpe won a Nobel Prize in economics for his analysis of how capital markets work and how investment returns can be measured and assessed for risk. From that body of knowledge come such concepts as "beta," which measures the volatility of a stock to the overall market.

But Sharpe and a group of prominent financial economists say measures such as beta won't help mutual-fund investors understand the risks they face in owning funds. This group, the Financial Economists Roundtable (FER), has come up with a refreshingly simple proposal. Its Policy Statement on Risk Disclosure by Mutual Funds, issued on Sept. 18, urges fund companies to talk about future investment risk in their prospectuses and shareholder reports and downplay statistical measurements based on past performance. The proposal is sure to draw fire from the fund industry. But it's an idea worth adopting.

Eighteen months ago, the Securities & Exchange Commission solicited comment on how to improve mutual-fund risk disclosure. It's a topic of intense interest. Witness the 3,700 comment letters sent to the SEC--"an extraordinary response," says a commission spokesman. By yearend, the SEC is expected to propose a new set of rules and guidelines for selling mutual funds.

BENCHMARK. Besides more forward-looking disclosure, the economists want more detail. Fund managers should "describe and quantify the expected relationship between their fund's future returns and the relevant market indexes." They want funds to choose narrower indexes that track say, large-cap growth stocks or small-cap value stocks, rather than broad indexes like the Standard & Poor's 500-stock index, and measure their returns by those indexes.

Recognizing that some funds aren't easily categorized, the FER suggests managers instead adopt a mix of indexes as a benchmark. The economists also want funds to say how likely they are to diverge from those indexes and the probable sources of the divergences, such as concentrating the portfolio in fewer stocks or industry sectors.

They also want the funds to assess their exposure to such factors as interest rates or currency fluctuations and to report how the fund performed relative to those factors. The FER recommends more frequent portfolio reporting. Now, funds need show their complete portfolios only twice a year. Funds will balk at doing any more, because they don't want to tip their hands to competitors. No problem, says the FER: Report twice a year, but show the positions as they were at the end of each month. Rather than getting two snapshots a year, investors would get 12--and a better picture of what's going on.

More forward-looking and detailed disclosure should give investors more realistic expectations about their funds. It will also help them build diversified portfolios of funds. The FER is simply applying the same practices to mutual funds that institutional investors like pension plans use on their investment managers. Define your investment niche, they say, and stick to it. The cost of straying can be high. Just ask investors in the Fidelity Blue Chip Fund. In 1995, blue-chip stocks soared but their mutual fund lagged because the manager had bought smaller company stocks.

Many mutual-fund companies will fight the FER's suggestions, arguing they could crimp the manager's ability to run the fund and could well hurt shareholders. For instance, if there were a sudden turn in the economy, a manager might want to substantially change his portfolio. "We're not saying a manager can't change his mind," says Sharpe. "We just want his best estimate."

Much of what the FER is proposing flies in the face of more than 50 years of fund practice. Funds don't like to make outright forecasts, fearing lawsuits if they miss the mark. The economists are well aware of that, too, and recommend that the SEC grant mutual funds leeway to make "honest estimates without fear mf later litigation." And while the economists want to see their ideas in practice, they prefer voluntary rather than mandatory compliance. The thinking is that investors will gravitate to funds that provide better disclosure and competition will force the others to follow suit.

It's going to be tough to craft a forward-looking description of fund risk that wins the acceptance of fund managers and can pass regulatory muster. But it's got to be an improvement on the history lesson investors get now.By Jeffrey M. Laderman

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